Scene: You an US investor has invested in JGB Japanese Govt. bonds 1 ] The economist estmates 1.5% increase in JPY over USD. IRP states JPY is at a 1.1% prem. So to hedge or not. Deal or No deal? 2] The economist estmates 0.5% increase in JPY over USD. IRP states JPY is at a 1.1% prem. So to hedge or not. Deal or No deal? First one is apparent, if someone can explain why second one needs to either hedged or not would be helpful. I will put up the answer shortly.
- not hedge because by not hedging you will get a 1.5% increase vs. hedging and locking in a 1.1% gain. 2) hedge because you can lock in a 1.1% gain on the currency vs. not heding and only gaining a 0.5% increase in the currency.
^ agree with strikershank… These questions are gimme’s… and if you logically play it through in your head, they make total sense.
agreed, I see it now!
The key to these questions is to compare the analyst’s expected outcome for the currency to that of the IRP. If the foreign currency is expected to appreciate more than IRP, do not hedge. if it’s expected to appreciate less than IRP, hedge.
IRP = holds in short run PPP = holds in long run Is that correct?
yes it is. IRP holds in short run based on covered int rate aribitrage theory Relative PPP holds in the long run based on inflation expectations
there are two IRP concepts, covered IRP and uncovered IRP covered IRP is what we usually refer as IRP, it deals with forward/spot differential and must hold by no orbitrage condition uncovered IRP is a similar concept and deals with expected spot/current spot differential, it combines covered IRP and international Fisher Equation, which assumes that real rates in the world are equal (which in reality is not necessarily true), hence uncovered IRP doesn’t alway hold Relative PPP is supposed to hold in the long-run, but sometimes it doesn’t, or the long-run when it eventually will hold maybe be very long